09 Dec Thinking Short And Long On Interest Rates: What We Expect From The Fed

When the Federal Reserve wraps up its December meeting Wednesday, Chairwoman Janet Yellen will most likely announce an increase of 25 basis points (0.25 percentage point) in its target for the federal funds rate.

The bump in the benchmark interest rate will get the headlines, but it’s just one piece of communication in a dialogue between the Fed and the markets. The Fed will also release its projections for long-term economic growth and interest rates. Together, the policy announcement and projections provide important context as investors set expectations for interest rates and asset class returns in the years to come.

Our analysis suggests that the Fed has been both too pessimistic about the present and too optimistic about the future. The risk of undue pessimism is that unnecessarily low rates will distort asset prices. The risk of undue optimism is that the prospect of unnecessarily high rates will stifle growth and roil the markets.

Short-term reality: It’s time for an increase

Today’s federal funds rate of 25 to 50 basis points is consistent with an economy that is still healing from the 2008-09 financial crisis. The reality, however, is different. The U.S. economy is in the midst of one of its longest expansions. The labor force is at full employment. Inflation pressures, though mild, are building.

If John Maynard Keynesand Friedrich Hayek returned from the grave to take our economic pulse, these intellectual foils would be united in their disbelief that the benchmark interest rate sits a shade above 0%. An increase would remove some (but by no means all) of the stimulus that has facilitated our recovery from the crisis.It would also reduce the risk of asset-price distortions.

Long-term reality: Slower growth, lower rates

Oddly enough,the same analysis indicating that the Fed has been unduly pessimistic about the short term suggests the opposite about the Fed’s long-term view.

At the start of 2016, the Fed projected that the federal funds rate would revert to a long-term average of 3% to 4% sometime after 2019. Rates in that neighborhood are consistent with growth (and inflation) rates similar to the 3%-plus expansions fueled by a growing labor force and heavy borrowing in the decades before the housing crisis.

That’s unlikely. Those one-time boosts are behind us. We estimate that the U.S. economy has a potential growth rate of about 2% per year. This is neither good nor bad; it’s simply a consequence of demographic, technological, and market forces that have been reshaping growth, inflation, and interest rates for decades.

Since early 2016, the Fed has lowered its rate projections, as illustrated in the chart below, but those projections remain a half percentage point or so too high. Could President-elect Donald Trump’s policies alter the long-term outlook? The post election spike in long-term Treasury yields (and tumble in bond prices)hints at this possibility, but it’s doubtful. An administration’s policies can temporarily nudge growth higher or lower, but they can’t change the longer-term trend.

Trending lower, but still too high

Fed’s longer-run rate projections

What to look for Wednesday

If the Fed does increase rates, as expected, I’ll be happy to earn a few more pennies on my money market fund. But more important than an additional quarter percentage point of interest is what we learn about the Fed’s short- and long-term expectations.The more closely those expectations correspond with what the data seem to tell us, the better for the economy and investors.

Note: All investing is subject to risk, including the possible loss of money you invest.